Tuesday, December 27, 2011

Dangers Of Machine Readable News?

The above chart is not the May 6th flash clash. It is an intraday chart of Constellation Energy from yesterday. If you ever wanted an example of how machine readable news and trading bots can wreck a stock in a matter of minutes, then look no further than the above chart. Let’s reconstruct the events as they happened:

11:58 – Headline crosses that “US sues to block Excelon acquisition of Constellation Energy “. CEG is trading at $38.93 at the time of headline.12:03 – CEG is halted due to a circuit breaker popping when the stock drops 10%. CEG last trade before the halt was $35.0312:08 – CEG reopens and shoots straight back up to $38 on heavy volume.12:10- Headline crosses saying “US settles with Excelon”

In the time span of 12 minutes, two distinct headlines ripped a stock up and down 10%. Some may say that the circuit breaker did what it was supposed to do and “allowed cooler heads to prevail”. And they would be partially correct. But the question remains, how does a stock drop that quickly and spring back up that quickly? The news was barely disseminated and the stock had already dropped 10%. Bids disappeared almost instantaneously and no doubt stop-loss orders kicked in. Volume weighted participation algos also no doubt chased the spike down as volume soared in the 5 minutes of trading before the halt.

The way this news was released is also very questionable. To announce a lawsuit and then a settlement 12 minutes later is not fair to investors. The companies involved should have requested a trading halt prior to the news announcement. But the fact remains that the news was disseminated immediately to the trading bots since it is now available in machine readable format. There was no time for a human to intervene to try and make sense of these headlines. The trading bots that subscribe to machine readable news services interpreted the news as bad and pulled out of the market. It is kind of ironic that earlier in the week Nasdaq announced that they bought a machine readable news company named RapiData. The WSJ said that “such machine-readable news is used by sophisticated trading firms that pull in signals from market prices and other sources to inform rapid-fire buying and selling of securities and derivatives contracts.” They described Rapidata as:

“RapiData packages and sends out figures from the U.S. Bureau of Labor Statistics and Treasury Department, according to the company. Staff enter data into RapiData’s systems, which check figures for accuracy and disperse them electronically when the government sends out the figures on its own. The firm uses high-speed fiber optic corridors and strategically placed servers that communicate the figures to trading systems in sub-second speeds. Such machine-readable news is used by sophisticated trading firms that pull in signals from market prices and other sources to inform rapid-fire buying and selling of securities and derivatives contracts.”

Not only do we now have a market that can whip stocks up and down 10% at the flicker of a headline, but now we have an exchange that is getting into the business of machine readable news. What ever happened to the real function of an exchange? Aren’t exchanges supposed to treat all investors fairly? Are exchanges that desperate for revenue that they have to get into the shady business of machine readable news so that they make sure that their best customers continue to have an advantage over everybody else? Maybe the demutualization of exchanges was not such a good idea after all. Their constant quest for profit places them in a conflicted position and makes their ability to treat all investors fairly very difficult.

Have to tell you, the above chart is the number one reason why I do not place tight stops or get too cute when I trade. In fact, I hardly ever day trade and have held onto positions that went 30% or 60% against me and eventually made a profit. Why? Because I knew that the stock was being manipulated by high-frequency trading (HFT) platforms and added to my position at the right time (traders will tell you never add to a losing position but that is total bullshit! Sometimes you're better off backing up the truck and going in heavy in one position!).

These markets dominated by HFT platforms can wreak havoc on any portfolio. The only way you can beat computers is by not playing the losing game of over-trading. Sure, some traders are good at it but most of them eventually get slaughtered.

Prohibit high frequency trading (HFT). HFT uses powerful computers and sophisticated software to take advantage of microscopic inefficiencies in markets around the world. HFT models will often sell a security within a few milliseconds of having bought it. Does that add any economic value to financial markets? I don’t think so. Does it create unwarranted volatility occasionally? I very much believe so. Although I am not in favour of the much discussed financial transaction tax proposed by the Germans and the French, ironically, a modest transaction tax (if it were global) would wipe out all HFT based strategies, and the world would be a better place as a result.

The reality is that many pension funds allocate money to hedge funds that engage in HFT. But pensions should also have internal teams set up to profit off these whacky movements in stocks. It's not hard to pinpoint them.

On any given day, I can spot weird moves in the stock market and if I had deep pockets of a pension fund, I'd jump on these opportunities every time these high-frequency crooks manipulate stock prices.

You might be asking what regulators are doing about this nonsense. Absolutely nothing. There are powerful interests (ie. banksters and hedgies) who want to continue ripping off clients and scamming the system. They claim to be providing more liquidity but the opposite is true. And the SEC is bent on covering up Wall Street crimes. All they need to do to stop these HFT shenanigans is reinstate the uptick rule. Watch clip below from a CNBC interview done earlier this year.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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